WARNING:
This Digest was prepared for debate. It reflects the legislation as
introduced and does not canvass subsequent amendments. This Digest
does not have any official legal status. Other sources should be
consulted to determine the subsequent official status of the
Bill.

As the Bill contains no central theme the
background to the various measures is included in the discussion of
the main provisions.

Main Provisions

Australia as a regional financial
centre

The measures in Schedule 1 were announced by the
Prime Minister on 8 December 1997 in the Investing for
Growth statement (Statement). The Statement contains the
following comment:

We recognise, however, the intensive
international competition for financial services activity. In
advance of major reform, we have decided to introduce specific tax
measures at a cost of $22 million(1) in revenue foregone in a full
year.

The measures are described in the
Explanatory Memorandum to the Bill as promoting
Australia's potential to be a world financial centre through the
provision of new tax concessions to supplement existing tax
concessions provided to the international banking and finance
industry. The Explanatory Memorandum states that the
measures ensure Australia's participation in the expanding global
trade in financial services.

There are four types of income tax concessions
provided in the measures. They are:

expansion of the existing section 128F withholding tax
exemption

expansion of the existing concessions provided for offshore
banking units

the provision of an exemption to foreign banks from the thin
capitalisation rules for funds raised under the section 128F
withholding tax exemption, and

provision of certain exemptions from the foreign investment
fund regime of the income tax law.

The measures contained in Schedule 1 were first
introduced into Parliament on 2 July 1998 in Taxation Laws
Amendment Bill (No. 5) 1998. This Bill lapsed when Parliament was
prorogued for the 1998 General Election. The Minister's second
reading speech to the Bill states that the measures in the first
Bill were amended following dialogue with industry bodies. The
amendments to the Bill were announced by the Treasurer by Press
Release No. 80 on 13 August 1998.

Australia imposes interest withholding tax of 10
per cent on interest payments from Australia to non-resident
lenders. In order to ensure payment of the tax the collection
obligation is imposed on the Australian borrower. While the tax is
imposed on the lender, lenders are generally able to pass any
interest withholding tax burden on to borrowers because lenders are
generally able to lend to borrowers in countries that do not impose
interest withholding tax on corporate fund raising. The net result
is that a borrower is required to pay not only the interest on the
borrowing, but also any domestic interest withholding tax.

To remove the burden of interest withholding tax
from borrowings by Australian companies an exemption was provided
for certain debentures issued overseas.(2) The main requirements of
the existing section 128F are that: the company issued the
debentures outside Australia; the interest in respect of the
debentures was paid outside Australia; the resident company issued
the debentures outside Australia for the purpose of raising finance
outside Australia; and, the public offer requirement is
satisfied.

The banking and finance industry has suggested
that interest withholding tax should be withdrawn from government
bonds. The industry has stated that, in light of the measures
contained in Schedule 1, it is an anomaly to retain withholding tax
on Commonwealth Government bonds which are traded widely among
overseas investors.(3)

Item 27 of Schedule 1 will:

repeal the existing requirement that eligible debentures be
issued outside Australia for the purpose of raising finance outside
Australia, and

repeal the existing requirement that interest in respect of
eligible debentures be paid in Australia.

Following the amendments Australian companies
will be able to issue debentures both overseas and in Australia.
They will be able to pay interest to overseas lenders either
overseas or in Australia. This relaxation will provide Australian
companies with more flexibility in raising finance. The
Explanatory Memorandum to the Bill states that this
measure is designed to encourage the development of the domestic
corporate debt market.(4) The Explanatory Memorandum also
states that by easing access to the exemption for financial
institutions, the government anticipates that the measures will
increase competition by lenders in the home-lending market and the
consumer loan market.

Currently, securities issued by an authority of
the Commonwealth Government, State governments and authorities of
State governments are eligible for the section 128F exemption
[subsection 128F(7)]. Under subsection 128F(7) an authority of the
Commonwealth, a state or an authority of a state is treated as a
resident company for the purposes of section 128F. This legal
fiction satisfies the requirement in subsection 128F(1) that the
exemption applies to interest paid by a company.
Proposed subsection 128F(5A) prescribes that the
new exemption will not apply to a company under subsection 128F(7)
or a central borrowing authority of a state or territory that
issues debentures in Australia (Item 29). Examples
of central borrowing authorities are listed in proposed
subsection 128F(5A). The following bodies are included in
that list:

the Tasmanian Public Finance Corporation;

the Queensland Treasury Corporation;

the South Australian Government Financing Authority;

the Western Australian Treasury Corporation;

the New South Wales Treasury Corporation;

the Treasury Corporation of Victoria; and

the Northern Territory Treasury Corporation.

[The digest refers to the entities described in
subsection 128F(7) and proposed subsection
128F(5A) as borrowing agencies.]

The drafting of Item 29 is
obscure. In addition, the proposed provisions and the comments in
the Explanatory Memorandum are contradictory. Item
29 was introduced in its current form on 2 July 1998 in
Taxation Laws Amendment Bill (No. 5) 1998 and then re-introduced
without alteration on 3 December 1998 in Taxation Laws Amendment
Bill (No. 4) 1998.

The use of the words 'issued in Australia' in
proposed subsection 128F(5A), without a reference
to the recipient of the debentures, may lead to a construction that
a borrowing agency cannot issue any debentures that qualify for the
withholding tax exemption. This construction is supported by the
heading in the Bill: No exemption for central borrowing
authorities.

An alternative interpretation of the provision
suggests that the borrowing agencies may not issue debentures in
Australia that are eligible for the exemption but that they can
issue debentures overseas that are eligible for exemption. This
construction depends on the reader being aware that a company can
issue debentures overseas and that such issues are unaffected by
the proposed amendment. Most readers would require assistance from
a source external to the Bill indicating that there is a difference
between a company issuing debentures overseas or issuing debentures
in Australia. The Explanatory Memorandum, however, does
not make this point. Under this construction the proposed
amendments may result in a significant easing of the section 128F
requirements for borrowing agencies because of the repeal of the
following existing requirements in section 128F:

that the debentures be issued overseas for the purpose of
raising finance overseas (paragraph 128F(1)(c));

that interest in respect of the debentures be paid overseas
(paragraph 128F(1)(d)); and

that the debentures not be issued to residents of Australia
(subsection 128F(5)).

It would appear from the Explanatory
Memorandum that this latter construction of the provisions was
unintended. Under the proposed amendments the borrowing agencies
are only subject to the requirement that the debentures be issued
overseas. However, proposed subsection 128F(5A),
as stated above, does not refer to a recipient. Consequently, under
this provision borrowing agencies will be able to: issue debentures
overseas for the purpose of raising finance in Australia; pay
interest in respect of the debentures in Australia; and issue
debentures overseas to residents of Australia. It is puzzling as to
why borrowing agencies would be prohibited from issuing debentures
in Australia but could issue the debentures overseas to residents
of Australia and pay interest in Australia.

According to the Explanatory
Memorandum, proposed subsection 128F(5A) may
not be an accurate reflection of the Government's intention. The
Explanatory Memorandum contains the following comment on
Item 29:

The wider exemption will not be available to
Commonwealth Government securities or securities issued by State or
Territory central borrowing authorities (sovereign issues).
However, the existing section 128F exemption applying to offshore
issues of debentures will continue to be available to these
entities.(5)

The Explanatory Memorandum is silent as
to the reason for the amendments proposed in Item
29 in relation to borrowing agencies.

In conclusion, it would appear from the
Explanatory Memorandum that, the intention of the
Government may have been to restrict borrowing agencies to a
version of section 128F that requires: debentures to be issued
overseas by borrowing agencies for the purpose of raising finance
overseas; borrowing agencies to pay interest overseas in respect of
section 128F debentures; and, borrowing agencies to issue
debentures overseas to non-residents. This result was not achieved
and it appears that the requirements for borrowing agencies may
have been significantly eased. Moreover, there is no statement as
to why borrowing agencies should be subject to special
restrictions.

Section 126 is an anti-avoidance provision. It
imposes income tax at the top marginal rate of tax, currently 47
per cent, on a company issuing bearer debentures, if the company is
unable to give the Commissioner of Taxation the name and address of
the holder of the debentures. This counters the avoidance
opportunities, that would otherwise be available to Australian
taxpayers, of holding bearer debentures and not declaring the
interest income in respect of the debentures. A person holding a
bearer debenture is able to require payment of interest without
disclosing the person's identity to the payer of the interest.
Bearer debentures are generally issued overseas because they are
readily traded.

The term 'permanent establishment' is defined in
section 6 of the Income Tax Assessment Act 1936 by virtue
of subsection 995-1(1) of the Income Tax Assessment Act
1997 to generally mean a place in Australia at which a person
carries on business. In relation to non-resident companies, a
permanent establishment is generally a branch of the company
located in Australia through which the company carries on its
business.

Item 23 proposes a
consequential amendment to section 126 because of the proposed
amendment to section 128F enabling section 128F exempt debentures
to be issued in Australia and interest in respect of the debentures
to be paid in Australia (see comments on Item 27
above). Item 23 proposes that section 126 will not
apply in relation to section 128F debentures to the extent that the
provision applies to non-residents not engaged in carrying on a
business in Australia at or through a permanent establishment
(generally a branch).

The proposed amendment appears to create
significant compliance problems for companies issuing bearer
debentures under section 128F. A company issuing bearer debentures
which are eligible for the section 128F exemption will usually not
know the identity of the bearer. This is a normal feature of
section 128F debenture issues. Consequently, the company will be
unable to determine if the bearer of a debenture is carrying on a
business in Australia through a permanent establishment. If, under
amended paragraph 126(1)(c) a company which has
issued debentures eligible for exemption under section 128F is
unable to assert that the person holding debentures does not carry
on a business in Australia through a permanent establishment, that
company will be liable to pay tax in respect of the interest paid
at the top marginal rate.

The term offshore banking refers to an
Australian entity entering financial transactions with overseas
customers. The transactions include borrowing funds, lending funds
and the provision of financial services. Provided these
transactions are isolated from the domestic banking system, tax
concessions are available for the income derived from the
transactions. Income derived by an offshore banking unit (OBU) from
certain listed activities is taxed at a rate of 10 per cent instead
of the ordinary corporate tax rate of 36 per cent. Interest paid by
an OBU is exempt from non-resident interest withholding tax.

The term OBU is defined in section 128AE.
Certain types of companies, prescribed in subsection 128AE(2) are
eligible to be declared by the Treasurer to be an OBU. Under the
existing provision only banks and corporations that carry on
foreign exchange dealings are eligible to be OBUs.

Eligible entities

The proposed amendments will expand the range of
entities eligible for the OBU concession. Item 24
expands the category of eligible entities to include registered
life insurance companies (proposed paragraph
128AE(2)(d)); and certain companies that provide funds
management services (proposed paragraph
128AE(2)(e); and any company that the Treasurer determines
in writing to be an OBU (proposed paragraph
128AE(2)(f)). As any company may be declared by the
Treasurer to be an OBU under proposedsubsection 128AE(2), it is unnecessary to
prescribe specific types of eligible companies in the 1936 Act.

Expanded range of OBU activities

The range of activities an OBU can undertake
have been expanded (Items 6-21).

Overseas charities

Overseas charities whose funds are managed by an
OBU are presently taxed on investments in Australian assets. To
encourage investment in Australia by overseas charities through an
OBU, proposed section 121ELA exempts the income
and proposed section 121ELB exempts the capital
gains of such charities from taxation (Item
22).

Reduction of OBU withholding penalty tax

An entity which is an OBU engaging in proscribed
activities may be liable to pay a penalty. The penalty rate of tax
is currently set at 300 per cent under the Income Tax (Offshore
Banking Units) (Withholding Tax Recoupment) Act 1988.
Item 38 reduces the penalty rate to 75 per cent.
The Explanatory Memorandum(6) to the Bill states that the
Government is of the view that the existing penalty is excessive.
The new penalty is described as being more in line with other
penalties for breaches of the OBU rules.

The thin capitalisation rules of the income tax
law(7) are an anti-avoidance measure to limit the amount of
deductible debt that may be claimed by a foreign owned Australian
enterprise. The thin capitalisation rules are limited to overseas
debt from related parties. Due to the preferential tax treatment
provided to debt investments, foreign investors have the incentive
to make investments in their own enterprises in the form of debt
and equity. The thin capitalisation rules set a fixed 'debt to
equity' ratio of 6:1 for financial institutions and 2:1 for all
other taxpayers. For every $2 lent to the Australian enterprise
(foreign debt) by a foreign investor, the foreign investor must
have equity of $1 in the enterprise (foreign equity). Foreign
equity is reduced if the Australian enterprise lends amounts to the
foreign investor. If the foreign debt to foreign equity ratio is
exceeded, the interest in respect of the excess debt cannot be
claimed as a deduction.

Foreign banks operating in Australia through a
branch are not able to access the section 128F interest withholding
tax exemption because they are not Australian companies. Such a
branch may arrange for a subsidiary company to be incorporated in
Australia for the purpose of borrowing funds overseas that are
eligible for the section 128F exemption; and then on-lending those
funds to the branch. Such loans are treated, under the existing
thin capitalisation rules, as a loan-back of equity by a bank
subsidiary to the foreign bank. This would result in the subsidiary
being ineligible for a deduction on loans from the foreign bank to
the subsidiary.

The amendments contained in Item
34 disregard, for the purposes of the thin capitalisation
rules, any on-lending of section 128F funds by an Australian
subsidiary of a foreign bank to the Australian branch of the bank.
This allows the Australian subsidiary of a foreign bank to lend
section 128F funds to its Australian branch (the foreign bank
itself) without suffering any consequences under the thin
capitalisation rules.

Divisions 50 and 51 of the Income Tax
Assessment Act 1997 provides an exemption from income tax for
a range of prescribed non-profit organisations such as charities. A
non-profit organisation may become a business enterprise and be
subject to income tax. This may occur if an organisation is floated
on the stock exchange and is then to become a business enterprise.
If a non-profit organisation changes its status to that of a
taxable entity certain tax consequences arise. One issue is the
valuation of an entity's assets for depreciation purposes.

When an entity changes its character from a
tax-exempt entity to a taxable entity, it must value its plant for
income tax depreciation purposes at its notional written down value
(NWDV). Under the existing law, a tax exempt entity's plant is
treated as being used, from the time of acquisition, for the
production of assessable income. In effect, items of plant are
treated as depreciating while held by tax exempt entities. This
process for valuing plant acquired from tax-exempt entities by
taxable entities could be avoided by the purchaser acquiring the
assets of the entity rather than acquiring the entity. In this
situation the purchaser is able to value the assets for
depreciation purposes at their purchase price which would often be
higher than the NWDV. The net result is that the purchaser is
entitled to a larger depreciation deduction by acquiring the assets
of the seller rather than the entity itself.

This avoidance problem does not arise in
relation to the acquisition of plant from sellers who are subject
to income tax. If a seller sells an asset for a value that exceeds
the depreciation value of the asset for income tax purposes, the
seller will be subject to income tax on the difference between the
depreciation value and the sale value of the asset. This process
captures the tax benefit the seller has obtained by depreciating
the value of plant to a level below its market value. A tax-exempt
entity cannot obtain the benefit of a depreciation deduction and
therefore it is indifferent to a sale process that values assets at
their market value rather than the asset's value in the entity's
balance sheet. This indifference provides potential for tax
planning by buyers to maximise the opening value of assets acquired
from tax-exempt entities.

The Treasurer announced in Press Release No.
84 of 4 July 1997 that the depreciation values were being
manipulated by the sale of assets to a purchaser. The Treasurer
stated that legislation would be introduced to allow the purchasers
of exempt entities, or the purchasers of assets owned by exempt
entities, only to claim depreciation based on the higher of the
NWDV and the undeducted pre-existing audited book value recorded in
the exempt entity's audited annual accounts. The Treasurer released
technical details, in respect of this measure, in Press Release No.
2 of 14 January 1998 and Press Release No. 45 of 30
November 1998. The measures contained in Schedule 3 were initially
introduced in Taxation Laws Amendment Bill (No. 4)(8) which lapsed
when Parliament was prorogued for the 1998 General Election.(9)

The Schedule 3 measures are designed to provide
a consistent method of valuing assets acquired from tax-exempt
entities regardless of whether the purchaser has acquired the
entity itself or the plant of the entity. ProposedDivision 58 sets out rules that apply in
calculating depreciation deductions and balancing adjustments in
relation to plant previously owned by an exempt entity.
Proposed Division 58 applies regardless of whether
a purchaser acquires the entity or the plant of the entity in
connection with the acquisition of the seller's business.

Proposed section 58-20 provides
a transitional entity (a previously tax-exempt entity) with a
choice of two methods of valuing its plant; the NWDV or the
undeducted pre-existing audited book value. Proposed
section 58-15 defines a 'transitional entity' as an entity
that was tax-exempt and then becomes an entity which is subject to
income tax. Proposed section 58-155 provides a
parallel valuation mechanism for purchasers of assets from
tax-exempt entities.

The term 'notional written down value' is
defined in proposed section 58-80. The term
'pre-existing audited book value' of plant is defined in
proposed section 58-10.

The intercorporate dividend rebate is a tax
credit mechanism to prevent the double taxation of dividends
flowing through a chain of companies. If a company pays a dividend
to a corporate shareholder, it will be able to obtain a credit for
any income tax incurred in respect of the dividend. This mechanism
allows a dividend to pass through several levels of corporate
shareholders without any taxation being levied on the dividend. The
dividend will generally be subject to tax in the hands of a
shareholder that is not a company.

Australian has an imputation system for the
taxation of companies. Under the imputation system a company paying
a dividend to shareholders is able to pass on a tax credit for the
company tax it has paid. Dividends which carry a tax credit are
called 'franked dividends'. Such dividends may be fully franked if
the company's income was taxed at the corporate rate of tax, which
is currently 36 per cent. Some companies are able to use tax
concessions to reduce their company tax. The consequence is that
such companies will be unable to fully frank their dividends. For
example, if a company claims a deduction for research and
development, its taxable income and in turn the income tax
liability of the company will be reduced. This results in the
company having fewer franking credits to distribute to
shareholders. Such companies may partly frank their dividends. Some
companies may not have a franking credit to pass on and may pay
unfranked dividends.

A taxpayer receiving a franked dividend may use
the franking credit against the tax payable on the dividend itself.
If there is an excess credit, the taxpayer may use the credit
against other income derived during the same income year. The
imputation rules do not allow excess credits in one income year
either to be refunded or to be carried forward to a future income
year.

The inability of a shareholder to obtain a
refund of tax or to carry forward a tax credit to a future income
year was an intended feature of the imputation system.(10) This
aspect of the imputation system creates the incentive for tax
planners to create arrangements that ensure that franking credits
are only paid to shareholders who can use the tax credit. The
income tax law contains strict rules to counter such practices.
There are rules to prevent the streaming of franked dividends to
certain types of taxpayers and unfranked dividends to tax-exempt
entities or taxpayers unable to fully use the franking credit.

The Government announced in its Tax Reform:
not a new tax, a new tax system that it would tax trusts like
companies to achieve tax neutrality.(11) The features of the
proposed system are:

A simplified imputation system involving full franking of all
profits paid to individuals or other entities outside consolidated
groups. The full franking would involve the taxing of all
distributed profits at entity level - with all distributed profits
then having attached imputation credits for the tax already
paid.

The introduction of entity taxation arrangements
would mean that trust distributions to charitable funds and
organisations are made from post-tax income. In order not to
penalise charities, provisions would be included in the law to
establish a registration process for such organisations. Only those
organisations listed on the register would be tax exempt or able to
qualify for gift deductibility. Registered organisation would also
be allowed to claim refunds of excess imputation credits for tax
paid at the trust level on donations to them by way of trust
distributions. (12)

The proposal to allow for the refund of franking
credits involves a significant change to the imputation system.
This would change the current premise of the imputation system that
some franking credits will be unused. This change will result in
taxpayers not having an incentive to enter avoidance schemes
because they will be able to obtain a refund for any excess
franking credits in respect of a year of income.

One method of avoidance is for a shareholder who
cannot fully use the imputation credit to sell the share shortly
before an announced franked dividend is paid. The sale price of the
shares reflects the value of the dividends and the attached
franking credits. The buyer acquires the shares in order to obtain
the franking credit and then resells the shares soon after the
dividend is paid. Through the technique of holding shares for short
periods of time, in respect of which a franked dividend payment is
imminent, some taxpayers are able to obtain significant tax
benefits.

The Treasurer announced in the 1997-98 Budget
that measures would be introduced to counter schemes designed to
increase the value of the franking credits to certain shareholders.
The measures are:

providing a specific anti-avoidance scheme for dividend
streaming;

ensuring that when a dividend payment is in effect an interest
payment, franking credits will not be provided;

inserting a new definition of 'class of shares' to ensure that
shares with similar rights will have to treated in the same way for
franking purposes; and

measures to prevent trading in franking credits. (13)

This Bill addresses the last three of the four
items. The first item was dealt with in Taxation Laws Amendment
Act (No 3) 1998. The measures contained in Schedule 4 were
first introduced into Parliament on 2 July 1998 in Taxation Laws
Amendment Bill (No. 5) 1998. This Bill lapsed when Parliament was
prorogued for the 1998 General Election.

The purpose of the amendments is to counter
arrangements designed to provide franking credits or an
intercorporate dividend rebate to persons who do not own shares or
are the owners of shares for a brief period of time to receive the
imputation credit. This anti-avoidance measure creates certain
tests that a shareholder must satisfy in order to be treated as the
owner of a share for the purposes of the imputation system and the
intercorporate dividend rebate system. As these persons do not want
the risk associated with holding the shares for a significant
period of time, the measures focus on the short-term nature of the
holding of shares in which a dividend has been announced.

Item 8 of Schedule 3 inserts
proposed Division 1A of Part IIIAA of the Income Tax Assessment
Act 1936. Proposed Division 1A contains the
requirements for a taxpayer to qualify for a franking credit, a
franking rebate or the intercorporate dividend rebate. To qualify
for a franking credit a shareholder must satisfy the holding period
rule and a related payments rule.

Proposed section 160APHO
contains the holding period test and a related payments test for
determining if a person is entitled to a franking benefit. The
related payment test requires that the taxpayer holding shares in
respect of which a dividend has been paid is not under an
obligation to make a related payment to another person
(proposed subsection 160APHO(1)). The measure
prevents a person from acquiring shares on the basis that future
dividends will be paid to another person. The avoidance arrangement
may be described as a conduit arrangement whereby the shareholder
receives dividends, takes the benefit of any franking credit and
then makes a payment to another person who may have the risk of
loss or chance of gain in relation to the shares.

The holding period test is that the shareholder
must have held the shares for set periods of time (proposed
subsection 160APHO(2)). In the case of non-preference
shares the shareholder must hold the shares for a continuous period
of 45 days (proposed paragraph 160APHO(2)(a)(i)).
For preference shares the holding period is 90 days
(proposed paragraph 160APHO(2)(a)(ii)). Under this
provision the shares must be held for the set time during the
'qualification period'. This term is defined in proposed
section 160APHD. In general the qualifying period ends 45
days after a share became 'ex dividend'. This term is defined in
proposed section 160APHE to mean the last day on
which a person acquiring shares is entitled to receive a dividend
in respect of the share. The sale price of a share, in respect of
which a dividend has been announced, will usually reflect the value
of the dividend because the announced dividend is present property
and not a mere expectation.

If a shareholder is able to materially affect
the risk of loss or opportunity for gain in respect of the shares,
such periods of time are not counted for the holding period rule
(proposed subsection 160APHO(3)). This measure
counters arrangements under which a person is nominally the
shareholder but the risk of loss and opportunity for gain are held
by another person, who cannot obtain the benefit of the franking
credit. To counter arrangements designed to avoid the holding
period test, proposed section 160APHH treats a
shareholder as having acquired or disposed of shares at a time
other than the time of actual acquisition or disposal of
shares.

Some shareholders who do not satisfy the holding
period and related payments test may nevertheless qualify for
franking credits if they hold shares in a managed and discrete
fund. Such taxpayers may elect under proposed section
160APHR to have their franking credit or rebate determined
under a set formula.

Background on the imputation system is contained
above in the section of the Digest titled 'Franking credits,
franking debits and the intercorporate dividend rebate'. Certain
shareholders, such as non-residents and tax exempt entities, are
unable to fully use franking credits. Tax-exempt bodies are unable
to use franking credits because the credits cannot be refunded.
Non-resident shareholders are unable to fully use the franking
credit because the non-resident dividend withholding tax is less
than the franking credit. Non-resident dividend withholding tax is
30 per cent but is reduced in most of Australia's double tax
treaties to 15 per cent. Fully franked dividends carry a tax credit
of 36 per cent. Non-resident taxpayers and tax exempt entities have
an incentive to enter arrangements to seek to fully use the
franking credits attached to their dividends.

A shortcoming of the existing legislation was
the expectation that non-resident taxpayers and tax exempt entities
receiving franked dividends would not attempt to fully use their
franking credits. This gave such shareholders the incentive to turn
these franking credits, through schemes, into a pecuniary benefit.
These avoidance practices have created the need for specific
anti-avoidance measures to prevent non-resident and tax-exempt
shareholders from receiving dividends with a franking credit in the
first place. The measures contained in Schedule 5 were first
introduced into Parliament on 2 April 1998 in Taxation Laws
Amendment Bill (No. 4) 1998. This Bill lapsed when Parliament was
prorogued for the 1998 General Election.

Schedule 5 will enact
anti-avoidance measures to prevent trading in franking credits by
restricting a significant source of franking credits likely to be
sold to resident taxpayers. The measures are targeted at companies
owned by non-resident shareholders and tax-exempt entities. This
measure will limit the imputation system to: companies which are
not wholly owned by non-residents; or companies which are not
tax-exempt entities.

The proposal treats persons who cannot
themselves receive a franking credit or franking rebate as
'prescribed persons'. Prescribed persons are non-residents and
tax-exempt entities (proposed section 160APHBF).
Companies in which 95 per cent of the shares are owned by
prescribed persons are treated as 'exempting companies'
(proposed sections 160APHBA and 160APHBB).
Exempting companies will be required to create franking credits and
franking debits and will be subject to the operation of the
imputation system. However, dividends paid by such entities will
only be exempt from non-resident dividend withholding tax. The
dividends will not give rise to a franking rebate or a franking
credit.

Transitional rules apply to former exempting
companies whose status changes. If the shareholding of a former
exempting company changes, it may be able to pay franking credits
to its Australian shareholders (proposed section
160APHBE). Such companies will be required to maintain two
separate franking accounts. The franking credits and debits created
by a company while it was an exempting company are eliminated on
its conversion to a non-exempting company (proposed
sections 160AQCNG and 160AQCNH).

Franked dividends paid by an exempting company
are generally only exempt from dividend withholding tax
[proposed paragraph 128B(3)(ga)]. This is the same
tax exemption which applies under the current law to franked
dividends [paragraph 128B(3)(ga)]. An exempting company may pay a
franked dividend which entitles the shareholder to a franking
credit in certain situations. If the shareholder is a life
assurance company, it will be entitled to a franking credit in
respect of any franked dividends it receives (proposed
subsection 160AQTA(4)). A similar exception is provided
for franked dividends paid under an employee share scheme
(proposed subsection 160AQTA(5)).

Background on the imputation system is contained
above in the section of the Digest titled 'Franking credits,
franking debits and the intercorporate dividend rebate'. One of the
features of the imputation system is the anti-streaming rules to
ensure that franking credits are distributed to shareholders in
proportion to their shareholdings. A company is proscribed from
streaming franked dividends to certain shareholders and streaming
unfranked dividends to other shareholders. Under the existing
provisions, franking credits must be distributed on a pro rata
basis to shares within the same class of shares. For example, all
shareholders holding A Class shares are entitled to receive the
same franking credit per share. By providing unfranked dividends to
taxpayers who cannot use the franking credit, a company may
increase the franking credits available for other shareholders.

Another avoidance activity is for an investor to
recharacterise a loan as an equity investment in order to obtain
the benefit of the intercorporate dividend rebate. Section 46D of
the Income Tax Assessment Act 1936 is designed to counter
such investment arrangements. Under section 46D dividends that are
really interest in respect of a loan are not eligible for the
intercorporate dividend rebate. Such dividends are called debt
dividends. The avoidance scheme is designed to make the interest
payment tax-free in the hands of the recipient.

Section 45Z of the Income Tax Assessment
Act 1936 extends the intercorporate dividend rebate to
dividends derived by certain persons through a trust or partnership
structure. The Explanatory Memorandum to the Bill states
that some trusts have used a technique to treat certain payments as
a dividend when in fact the payment is equivalent to
interest.(14)

The measures contained in Schedule 7 were first
introduced into Parliament on 2 July 1998 in Taxation Laws
Amendment Bill (No. 5) 1998. This Bill lapsed when Parliament was
prorogued for the 1998 General Election.

The Explanatory Memorandum states that
trust and partnership structures may be used to enable the
streaming of franking credits to certain persons.(15) According to
the Explanatory Memorandum such structures can effectively
allow certain persons to receive interest-like returns that are
fully franked. Persons who lend funds directly to a company and
receive interest from the company are denied both franking credits
and the intercorporate dividend rebate under the income tax
law.

an amount, called the distributed amount, is distributed to a
corporate taxpayer in respect of an interest in a trust or
partnership

an amount, called the attributable amount, that is part of the
distributed amount, was attributable to the payment of a
dividend

the attributable amount was paid to the taxpayer in respect of
an interest in a trust or partnership that was acquired after the
commencing time (7.30 pm 13 May 1997)

the attributable amount was paid to the taxpayer in respect of
an interest in a trust or partnership or is attributable to a
financing arrangement, and

the payment to the taxpayer of either the attributable amount
or the distributed amount may reasonably be regarded as equivalent
to the payment of interest on a loan.

If the above tests are satisfied
proposed subsection 45ZA(3) directs that such a
taxpayer is not entitled to the intercorporate dividend rebate
under sections 46 or 46A.

Proposed subsections 160APQ(4), 160APQ
(5) and 160APQ (6) prevent shareholders from obtaining a
franking credit if a trust or partnership distribution was paid
under a finance arrangement which could reasonably be regarded as
the payment of interest on a loan.

A critical element of both of the above measures
is the requirement that the payments 'may reasonably be regarded as
the equivalent of interest on a loan'. This phrase is not defined
and it is a matter which will have to be decided on a case by case
basis. It is almost impossible to specify the criteria against
which one may determine if a payment is the equivalent of interest.
This requirement provides the opportunity for the overall
arrangement to be examined to determine if a payment has the form
of a dividend which in substance is a payment of interest. This
aspect of the measure, some may argue, will create uncertainty for
some shareholders.

The Menzies Research Centre Public Fund (the
Centre) was established in 1995 with the stated aim of providing
research into economic, social, cultural and political policies to
enhance individual liberty, free speech, competitive enterprise and
democracy. In practice, the Centre could be classified as a Liberal
Party 'think-tank'. It is broadly equivalent to the Evatt
Foundation which was established in 1979 and performs similar
functions for the Labor Party.

The funding of organisations bearing the name of
politicians has a relatively long history, however, it must be
noted that generally such bodies engage in a range of functions as
well as party research. The Menzies Foundation was established in
1978 and, it is reported, that it subsequently received
approximately $4.4 million prior to the Liberal Party losing
government in 1983. In relation to the Evatt Foundation, an initial
Government grant of $250,000 was made in the 1984-85 Budget and
this continued for eight years, comprising a total of $2 million.
Further indexed grants were made in later budgets, the reported
total contribution being approximately $3 million. In addition, the
Murphy Foundation which was established in 1987 was reported to
receive total grants of approximately $1.2 million prior to the
election of the current government. The current government ceased
making grants to the Murphy Foundation. It has been reported in the
press that the sum of grants to such foundations is: Menzies: $4.62
million; Evatt: $3.24 million; and Murphy: $1.17 million.(16)

On 9 October 1996 the Minister for
Administrative Services announced that annual grants would be made
to the Menzies Research Centre and the Evatt Foundation and that
both organisations would receive $100,000 per year. The Press
Release announcing the grants did not specify if the grants were to
be indexed or for how long they would continue.(17)

In relation to tax deductions for donations to
such foundations, which are dealt with by this Bill, the Treasurer
announced on 10 October 1996 that donations to the Menzies Research
Centre of $2 or more would be deductible. Currently, donations of
$2 or more are deductible if made to the Menzies Foundation or the
Evatt Foundation as philanthropic trusts, while such donations to
the Murphy Foundation are deductible as an education body. The
measures contained in Schedule 6 were first introduced into
Parliament on 2 April 1998 in Taxation Laws Amendment Bill
(No. 4) 1998. This Bill lapsed when Parliament was prorogued for
the 1998 General Election.

Schedule 6 provides an income tax deduction for
donations of $2 or more to the Menzies Research Centre Public Fund
for donations made after 2 April 1998. This was the date on which
the measure was to commence when first included in a Bill
introduced in to the previous Parliament. The Centre will be
classified as a research recipient.(18)

Under the proposed goods and services tax (GST),
donations to non-profit organisations will not be subject to
GST.

1. The Minister for Financial Services and Regulation, the Hon
Joe Hockey MP, stated in his second reading speech that the entire
package of measures in Schedule 1 was estimated to cost $22
million. However, the Explanatory Memorandum to the Bill
is not clear on the actual revenue cost of the measures in Schedule
1. In the section of the Explanatory Memorandum titled
'General outline and financial impact' (p 3) the package of
measures contained in Schedule 1 is estimated to cost $22 million.
The section states that:

The package is estimated to cost $22 million in
a full year. There may also be an indirect cost to the
revenue as a result of the proposed FIF [foreign investment fund]
exemption because of the increased investment in US FIFs. The cost
to the revenue is unquantifiable because the amount of capital
transferred to US funds will be dependent on prevailing economic
conditions and on the investment strategies of Australian funds
managers.

While the quote states that the foreign
investment fund measures are unquantifiable, the section titled
'Summary of Regulation Impact Statement - Part 2 of Schedule 1,
Foreign Investment Funds' (p 5) states that:

The cost to the revenue of providing the
[foreign investment fund] exemption is expected to be $2 million in
the 1998-99 income year and $3 million annually for the subsequent
income years.

The Explanatory Memorandum is
contradictory, however, on the revenue cost of the foreign
investment fund measures.

The proposed legislation is estimated to
negatively affect revenue to the amount of $22 million in a full
year.

According to this part of the Explanatory
Memorandum the amendments proposed in Schedule 1, other than
the foreign investment fund measures, will have a revenue cost of
$22 million. According to pp 4-5 of the Explanatory
Memorandum, the total cost of the measures will be $24 million
in the 1998-99 income year and $25 million in the following income
years. These amounts each exceed the revenue cost quoted by the
Minister in his second reading speech in respect of the Bill.

8. There are two Bills with the title Taxation
Laws Amendment Act (No. 4) 1998. The
first Taxation Laws Amendment Bill (No. 4) 1998 was introduced in
the House of
Representatives on 2 April 1998. It was passed by the House on 3
June 1998 and
was introduced in to the Senate on 22 June 1998.

9. This measure was first considered in Bills
Digest No. 193 1997-98.

10. At para 4.6, Explanatory Memorandum
to the Bill, it is stated that it was intended
that some shareholders would be unable to use a franking credit
attached to a
dividend.

Bob Bennett
11 March 1999
Bills Digest Service
Information and Research Services

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